When the disrupted bite back…

Posted by Liz Rees in Weekly musings category on 24 Oct 19


We hear all the time about up-and-coming businesses attempting to disrupt the status quo of established companies. It’s all too easy to get sucked into the latest hype but a great idea is no guarantee of success. In fact, recent cases of new entrants losing their way makes me wonder whether we should sometimes stick with the incumbents. Without doubt, identifying the winners is crucial to optimal portfolio performance.

Change is all around

Climate change, demographics, urbanisation and advances in healthcare are all creating demand for new products and services. For example, the transition to renewable fuels is expected to involve huge investment as energy infrastructure is rebuilt or upgraded. However, this does not mean there is easy money to be made.

Technology certainly breaks down barriers to entry but some of the most exciting concepts don’t make it as a result of weak management, lack of funding or a variety of other reasons. So disruption of an industry need not spell doom for existing players.

Opportunities, even in emerging industries such as artificial intelligence, can be exploited by established companies looking for new growth avenues. For example, Microsoft is a leader in AI (Artificial Intelligence) while Disney and Apple are encroaching on Netflix’s first mover advantage in streaming entertainment services.

Energy and mining

There has been a plethora of start-ups in fields such as supply of ‘green electricity’ to homes and offshore wind generation. Unfortunately, the failure rate is high mainly due to lack of scale and intense competition. Such businesses often struggle to attract capital because few can offer returns to match oil and gas exploration. Winners are likely to be larger utilities which generate the necessary cash flow operate renewable asset programmes.

PV Crystalox Solar, a small UK listed business, which developed silicon wafers for solar power systems has seen its share price fall by over 80% this year due to price undercutting from Asia. China is leading the way in solar panels, wind turbines and batteries and, unless Europe and the US can fight back quickly, may dominate markets associated with a lower carbon economy.

In the mining sector, Sirius Minerals is attempting to bring on-stream a major polyhalite mine in Yorkshire. Polyhalite is a fertilizer, considered to be safe and environmentally friendly, used for sustainable farming. Its future hangs in the balance as investors prove unwilling to provide funding for a project where profitability is a long way off.

Meanwhile, FTSE 100 miner BHP, has pledged to spend $400m over the next five years to reduce carbon emissions and has tied executive pay more closely to environmental targets. Similarly Royal Dutch Shell is directing a large portion of its research and development spending towards renewable energy.

Electric vehicles

This is a high growth market and the UK’s desire for all new vehicles to be electric by 2040 should bring opportunities. Yet Dyson has just shelved an ambitious £2bn project to develop an electric car. After two years completing designs and patents, they decided it is no longer commercially viable. Other start-ups, such as Nio of China, have also found it difficult to compete against the deep pockets of the incumbents.

Manufacturers with well-known brands have upped their game. VW has committed around EUR 44bn to the market and will be able to absorb losses for a long time. Tesla had the advantage of being first to market and was able to raise substantial capital but even here the jury is out on whether it will ever achieve mass market penetration.

Financial services

Metro Bank was one of the first ‘challenger banks’ to embark on a shakeup of up the traditional culture, introducing longer opening hours and enhanced services. However, it seems to have expanded too rapidly and recently uncovered serious accounting errors.

Mistakes like this cost a business dearly. Chairman and co-founder Vernon Hill was forced to step down and Metro Bank shares tumbled further when a £350m bond issue to shore up its balance sheet had to offer a 9.5% coupon to entice subscribers. What’s more, the big banks are quietly fighting back with their own investment in digital starting to pay off.

Retail - widespread pain

The future of physical stores has been threatened by online shopping and a significant number have literally shut up shop. Online specialists have prospered but now cracks are starting to show- one time darling ASOS is experiencing tougher times.

Meanwhile, high street stalwart Next has demonstrated how a well-known brand can turn the trend to its advantage. It focused investment on its website and highly efficient distribution systems, and now sells more online than through retail outlets which are used as collection and return points.

Property

Shared workspace provider WeWork was once the most valuable US start-up, worth an estimated $47bn. However, a proposed IPO flopped when professional investors decided there was really nothing high tech about short-term office leases. The company was forced to seek a rescue package to avoid bankruptcy.

FTSE 250 group IWG has operated a similar model since 1989, albeit with less flamboyant marketing, and has a far more modest valuation as well as being profitable. Furthermore, listed property companies and direct property funds are adapting to urbanisation trends with integrated work, residential and leisure developments.

A diversified investment strategy

Disruption is a force that cannot be ignored. Nevertheless, consumers like brands they know and trust and to challenge the status quo requires deep pockets. Finding winners requires skill and an element of luck. We cannot be certain whether the likes of Uber and Deliveroo will reach the scale of Amazon which is why diversification, by blending the old and new in a portfolio, makes sense.

Of increasing importance is engagement by fund managers to ensure companies adopt a sustainable path. The extent to which ESG (Environmental, Social and Governance) considerations are incorporated should be made clear in a fund’s objectives. Sustainability is at the heart of Morningstar bronze-rated Royal London Sustainable Leaders fund which seeks UK companies that have a positive impact on the environment, human welfare and quality of life.

Some investors may wish to exclude all fossil fuel exposure from their portfolio while others may acknowledge that some of these companies are spending billions reducing their carbon footprint and transitioning to renewables. We can recall that oil was once applauded as a substantial environmental improvement over coal power.

Funds with a broad thematic approach may look for the best opportunities in sectors facing disruption. Morningstar silver-rated Artemis Global Select fund seeks quality businesses that have demonstrated they can adapt and survive in an evolving world. Specialist funds, such as technology and biotech, may offer the potential to uncover big winners but, as they carry greater risk, should be a limited part of any portfolio.

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.

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